In 1906, Italian economist Vilfredo Pareto made a fascinating discovery: he found that 20% of Italy’s landowners owned 80% of Italy’s land. In and of itself this may not strike you as all that fascinating. However, Pareto—and many economists in the century following his work— came to find many other instances of this 80-20 ratio. Read on to learn about how the Pareto Principle applies to business, and how you can use it to understand and even improve your operations, team management, and sales/marketing strategies.
Where the 80-20 Principle Occurs in Business
The Pareto Principle, or “80-20 Principle” is not just limited to land ownership. For example, the richest 20% of the world’s population receives about 83% of the world’s income each year. The Pareto Principle is especially common in natural phenomena and human behavior, which is where it finds its application to business.
The 80-20 Ratio Happens on Teams
In many organizations, about 80% of all the productive work is done by about 20% of the employees.
This does not necessarily mean that 80% of the employees are slacking off, as you might imply. It simply means that many organizational structures tend to follow a pattern in which certain team players end up handling all of certain kinds of work, while other team players act to support those key members.
On a football team, certain players score a disproportionate number of points while other team members back them in supporting roles. The center (who almost never scores) is working just as hard as the quarterback (who often does).
The 80-20 Ratio with Customers
On the other hand, sometimes the principle does indicate that one set of people is doing a better job, making more or less trouble, or bringing in more or less revenue, than another. A commonly expressed instance of the Pareto principle is that 20% of your customers produce 80% of your complaints. This is an instance where those 20% of the customers probably are, in fact, the people who are difficult to please.
Another common example of the 80-2o ratio with customers is that 20% of your customers produce 80% of your sales. This is why it’s so important to work on customer loyalty. The small group of your most loyal customers may be your most valuable, not just because they evangelize your brand but also because they may very well be making the most purchases.
Two Caveats with the 80-20 Principle
There are two critical things to bear in mind about the Pareto principle. One is that the principle neither requires nor precludes a moral judgment about the people being described in the data.
The other is that the principle is an empirical observation, not a theoretical prediction. If some element of your business does not follow the principle, that doesn’t mean you’re doing it wrong, it just means that it doesn’t happen to follow the principle.
On some football teams, the quarterback scores half the points and on other teams, he uses a different strategy and throws more touchdowns than he runs in. Given these caveats, it’s important to assess whether the Pareto Principle applies to your business. If it doesn’t, applying it to your marketing strategy may not be the best idea.
Applying the 80-20 Ratio to Your Business
So how can you apply your understanding of the Pareto principle to marketing your business?
One invaluable application is the identification of your true key customers. These might be the 20% of your customers who generate the bulk of your sales, but are more likely to be the 20% of your customers who generate the bulk of your profits. In some businesses, these are the same people, but in many businesses, they are NOT the same group!
A marketing initiative aimed at increasing the number of buyers may end up boosting your overall sales but leave profits flat or even declining, if most of your buyers aren’t actually all that profitable and it’s only a select few who really fill the company coffers. It’s important to know where your profitability is coming from, and whether there is any link to loyal or repeat customers.
Another application is to recognize where the sales drivers within your company are, but you must do so with a deep understanding of the way your organization works. Oftentimes, business owners misidentify which 20% they should be looking at.
For example, a distribution company might notice that the 20% of their employees on the sales team generates nearly all the sales. Meanwhile, the other 80% of the company works in the warehouse and generates no sales.
A misunderstanding of the principle might lead you to allocate all the bonus money and prerequisites to the sales team. But now, the highly-incentivized sales team is generating money like crazy, but the company doesn’t collect much of it because the warehouse staff all quit.
A solid understanding of the organization, however, would lead you to recognize that both sides of the operation are critically important, and to ensure that both sales and fulfillment are getting positive feedback and incentives to do good work.
With that done, you can look at the sales force itself, and realize that among your salespeople, 20% or so of the workers are bringing in the majority of the business. You can recognize that difference in performance and give your high-productivity sales staff the tools they need to maximize their performance, and either pare back the less productive 80% or find out what’s holding them back and correct the issue.
Using the 80-20 Ratio in Marketing
When you engage in marketing efforts, you can analyze your channels to find out where the bulk of your results are already coming from. This is an area where your judgment as a business owner ought to be informed, not controlled, by the Pareto principle.
For example, you may discover through data analysis that the 20% of your marketing dollars going to social media are producing about 80% of your new customer stream. Does that mean you should double your investment in Facebook and Instagram marketing at the expense of your print campaign? It might!
However, you may feel that your social media campaigns, while successful, are also at the limit of their contribution to your growth curve. This is where your experience comes into play. Pareto can show you where your existing successes are coming from, but he can’t predict where they will come from tomorrow.
The basic logic of the Pareto principle is simple: the majority of the results of a process or system are usually caused by a relatively small number of causal factors. Analyzing your results with the Pareto principle in mind can show you the channels and segments that are the most responsive to your initiatives, as well as the areas of your business that are more important in terms of outcomes. This will help you make the most of your marketing efforts.